How to help clients understand annuities

Annuities have a strange reputation. Some advisors view them as the pariah of the financial services profession. Others see them as useful tool, and for those who sell them, they are the be-all and end-all of financial security.

But behind all of that emotion, they should be seen for what they are: a transfer of risk from the investor to an insurance company. The insurance company will provide a range of “guaranteed” rates of return without opening an investor up to the entire risk of the market. An investor won’t experience the lows of market performance, but also not the highs.

That said, these products are made much more complex with various riders, ranging from impaired risk to long-term care, commuted payout and the plethora of guaranteed income and withdrawal riders. It’s no wonder that investors find these investment vehicles complicated and can feel duped once they fully understand all the fees that are involved.

I have been working through a case with a current client who inherited a number of investment assets from her mother, the largest of which is a non-qualified annuity of $380,000. During the course of interviews with other advisors, the popular advice was to elect the stretch provision and take the RMD over her lifetime.

The reasoning behind this was to continue to defer taxation on the lion’s share of the account and allow it to grow throughout her lifetime. Most advisors then suggested that they manage the annuity for my soon-to-be client, which caused her to shy away from hiring them.

While not bad advice, if these advisors had dug further into this client situation, they would have realized a more appropriate course of action.

My client is 38. Her husband is employed, while she stays at home and raises their two children. They live in a low cost-of-living area of the country and live on just $35,000 per year, utilizing every cent of the earned income tax credit. This inheritance was going to change their life in many ways and it was daunting. There was a great sense of duty towards this money as my client’s mother had passed away quickly from a sudden illness.

The lack of financial confidence was apparent during our meetings, so it was clear that this plan would need to be implemented slowly. As we worked through a planning process — which they paid for as a project, and not based on AUM fees – we left the recommendation on the annuity as one of our last action items. It was the most complex part of their plan, and I wanted to instill a sense of financial confidence before we tackled the various options.

Because of their low-income status, recent changes in the federal tax law and the family’s upcoming cash needs, they would need access to this annuity far beyond the RMD. We considered several scenarios, including stretching the annuity, doing a 1035 exchange, executing a five-year withdrawal plan and liquidating the annuity, but in the end, they decided that they wanted to exchange the annuity for another product with cheaper ongoing investment costs.

As I reflected on their decision, based on book-based financial planning knowledge, this was the best option. But knowing them as a couple, I knew this wouldn’t meet their needs.

Changing tactics, I decided to show them the tax consequences of taking an RMD, liquidating 50% of the account and liquidating 100% of the account. As we looked at tax pro formas utilizing new tax rules, and adjusting other areas of their plan, they were able to see that liquidating the annuity didn’t pose a significant tax burden.

Given the basis of the annuity (~40% of account value), they were expecting a big tax bill, but even liquidating the entire account would have only left them in the 22% tax bracket. After discussions, they decided to liquidate the account over two calendar years, giving them more flexibility with their inheritance and leaving the world of annuities behind forever.

What conversations caused them to change their minds?

Aim for complete understanding: Coming into our relationship, my client had told me that advisors had spent 30 minutes with her explaining her various options. But in our conversations, we spent almost two hours discussing the options and various tax consequences. I laid out everything in dollar terms and not percentages, and showed her how different approaches would affect her family now and in the future. This required hours of preparation on my end, but was well worth it in the end.

Understand the end game: In almost every plan I do, I take my client through visualization exercises. With this plan – and with this account in particular – I asked this couple if they would prefer having an annuity at retirement which would pose some withdrawal restrictions, or an account that may have a lower balance, but would be theirs to do with as they please. Dollar values rarely become the winning argument in exercises like this. Instead, freedom, flexibility and transparency often drive decisions.

Don’t underestimate your client’s abilities: At the start of our relationship, I was told that I would have to provide a lot of education as they were still learning about all their financial choices. Two months later, I was taking my client through detailed tax pro formas at their request to show them various scenarios.

If I would have dumbed down my presentations, my recommendations might not have had the same credence to them. By showing and educating them on how these recommendations came to light, they appreciated the education and also made their decision with confidence.

When dealing with clients and reviewing their annuities, the first challenge can be understanding the complexity of the product and its various nuances. But once you come to your final recommendation, take plenty of time to customize the delivery of this advice to your clients. Building trust with your clients is key if you don’t want them to second-guess your recommendations.